Tapping into behavioural biases can create repeatable returns

Classical economics assumes the existence of a group of perfectly rational human beings who carefully weigh up the pros and cons of any financial decision. But these mythical beings have been hard to find in real life.

11/12/2014

Classical economics assumes the existence of a group of perfectly rational human beings who carefully weigh up the pros and cons of any financial decision. But these mythical beings have been hard to find in real life.In truth, people take sometimes irrational short cuts to help them make financial choices. This realisation has led to the development of alternative theories aimed at identifying these short cuts or ‘heuristics’ – speedy ways of solving difficult problems.

Although heuristics have long been known about, it has never been clear how investors can profit from them. This article draws on the work of behavioural economists to identify three groups of heuristic biases – prospect theory, extrapolation and herding, and ambiguity aversion and availability bias – and then looks at the financial strategies that can profit from these hard-wired behavioural patterns.

1. Prospect theoryThe systematic inconsistencies that individuals bring to their decision-making processes have led to the development of prospect theory1. One key finding from this has been that investors are loss averse2, suggesting that there ought to be excess demand for insurance strategies that reduce downside risk. In other words, the average investor should be willing to pay over the odds to protect themselves from harm. If the behaviourists are right, it ought therefore to be possible to extract an excess risk premium over time for a disciplined strategy that underwrites that risk.

We believe there are two distinct types of investment themes that can be used to exploit this psychological intuition:

a. Shorting volatility on equity marketsThe average investor not only tends to exhibit loss aversion, but also to overestimate the probability of extreme events. This leads to anxiety about a possible loss of capital. As a result, there is consistently high demand for financial assets which can avoid the discomfort caused by significant capital losses. One example is the equity put option. There tends to be a greater demand for puts than for calls as most investors are natural holders of risk assets (like equities). Risk aversion means they prefer to protect these assets from falls, rather than provide themselves with the opportunity for further upside by buying calls.

The heavy demand for this insurance means investors have a tendency to overpay. Consequently, a strategy that systematically underwrites the insurance they seek should earn a positive premium over the long term. On the other hand, the underwriters are themselves likely to suffer losses in the event of a macro shock. This tends to result in a low, even distribution of results with larger tails (‘high kurtosis’), particularly to the left (‘negative skew’). Despite these infrequent outsize losses, the strategy should still generate a small and generally consistent performance overall. A similar pattern of returns can be seen with currency carry trades (Figure 1).

b. The foreign exchange carry tradeCurrency carry is the return an investor can get from borrowing in low yielding currencies – those where interest rates are low – and investing the proceeds in higher yielding ones3. On the basis that investors generally dislike inflation, they should require a lower premium (interest rate) for holding a currency managed by a central bank with a more credible record on containing inflation. Conversely, higher yielding currencies should naturally be perceived as riskier.

It follows that an investment strategy that systematically withdraws liquidity from safe assets (in this case, currencies associated with low interest rates) and allocates it to more risky assets (currencies carrying a higher rate) is equivalent to an insurance policy that underwrites a broad systemic risk. This is because, at times of market stress, it will provide liquidity for investors in risky assets who wish to sell and seek safety in higher quality assets. The expected currency carry therefore becomes the risk premium offered to the provider of insurance against that systemic risk.The principal risk of this strategy is that it is sensitive to liquidity shocks and therefore subject to significant drawdowns. It also exposes the investor to idiosyncratic country risk, which can increase in the event of any big slowdown in global growth (Figure 1). Even so, as with the previous strategy, despite the occasional large loss, an investor should still enjoy a consistently positive return overall.

1David Kahneman and Amos Tversky, ‘Judgment under Uncertainty: Heuristics and Biases’, Science, vol. 185, no. 4157 1974; and D. Kahneman and A.Tversky, ‘Prospect theory: an analysis of decision under risk’, Econometrica 47. 2A simple example of loss aversion (and framing) is that it is easier to encourage people to pay a bill by penalising late payment than by offering them a discount for early payment. Loss aversion is in fact equivalent to the traditional concept of the diminishing marginal utility of wealth.3This is an uncovered interest rate arbitrage, which should not exist in theory since the currency with the higher interest rate ought to depreciate relative to the currency with the lower rate. This, however, ignores the actions of central banks and governments which may see it as in their interest to ensure that this trade rewards investors.

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